The global outlook remains clouded by the sovereign debt problems in Europe. Notwithstanding
this, there has been a general improvement in sentiment over the past month
or so following further measures by the European Central Bank and European
governments. Equity and commodity prices have picked up after earlier falls,
and bond yields in a number of European countries have declined. Nonetheless,
further measures by European policymakers will be required over the months
ahead for public finances in a number of countries to be placed on a sustainable
path.

Largely reflecting developments in Europe, official forecasts for global growth have
been revised lower, with growth in the world economy now expected to be below
trend in 2012, but nothing like as weak as 2008–09. As has been the case
over recent years, a significant share of overall growth is expected to come
from the emerging market economies, particularly those in Asia. In contrast,
in many of the advanced economies a broadly synchronised fiscal consolidation
is taking place at a time when both households and financial institutions are
also deleveraging, which is likely to be contractionary for growth. As a result,
limited progress is expected over the next couple of years in reducing unemployment
in these countries.

In Europe, the economy appears to be in recession. In contrast, the US economy has
improved over recent months after a soft patch in mid 2011, with the unemployment
rate declining and tentative signs of improvement in housing activity. In east
Asia, growth has slowed, partly reflecting weaker export demand as well as
the earlier policy tightening. Growth in China has moderated, as was intended
by the Chinese authorities, and is now running at a more sustainable pace.
Inflation in China has also moderated, and the authorities are continuing with
measures to contain property prices, which is having a dampening effect on
the real estate industry.

While spreads on bonds issued by a number of European governments remain elevated,
they are noticeably lower than they were in late 2011. In the major bond markets,
yields remain near their historic lows and, in Australia, yields on 10-year
government bonds recently fell to 50-year lows, with significant purchases
by non-residents, including sovereign asset managers. The Australian dollar
has appreciated against major currencies over the past couple of months and
is currently not far below the multi-year peaks reached last year, even though
commodity prices have declined since then.

Bank debt markets globally were particularly dislocated in the latter part of 2011,
with minimal issuance, partly reflecting concerns about the European banking
system. Over the past month, conditions have improved, with issuance picking
up markedly, but spreads on bank debt are significantly higher than they were
in the middle of last year. Indeed, some large corporates are now able to raise
funds in the capital markets more cheaply than banks with a higher credit rating.
These global developments have had an effect in Australia, where there has
been a step-up in the banks' overall cost of funding relative to the cash
rate.

The recent improvement in sentiment is reflected in commodity prices, which have
risen over the past couple of months after falling over the second half of
last year. The price of iron ore has picked up, reflecting ongoing strength
in Chinese demand, although global steel production has softened. Energy commodity
prices have remained at high levels, partly due to geopolitical factors. Australia's
terms of trade reached a record high in the September quarter, and are estimated
to have declined somewhat in the December quarter.

The Australian economy continues to record moderate growth, with GDP estimated to
have increased by around 2¾ per cent over 2011, which is a little below
average, partially reflecting the extreme weather events early in the year.
Conditions continue to vary significantly across industries, with the economy
undergoing considerable structural change in response to high commodity prices
and the accompanying high exchange rate. Real incomes in Australia have received
a significant boost over recent years as a result of the rise in the terms
of trade, but the effects are being felt unevenly across the economy.

Overall measures of business conditions and confidence are at, or slightly below,
average levels, after recovering from their falls around August. Business credit
has also increased slightly over the second half of 2011 after falling over
the previous year. Credit conditions, however, remain quite tight for the commercial
property industry.

In the resources sector, investment is expanding at a rapid pace. As a result, it
is likely that over the next year the level of business investment in the economy
will reach its highest level, relative to GDP, in at least half a century.
Since the previous Statement, another large liquefied natural gas (LNG) project has received
final investment approval, bringing the total value of LNG projects approved
or under construction to around $180 billion.

In contrast, conditions in a number of other sectors remain subdued, with the high
exchange rate, soft consumer demand for goods, the scaling back of public investment
and weak building construction all weighing on activity. The recovery in coal
production from the Queensland floods has also taken longer than initially
expected, with Queensland coal exports yet to return to pre-flood levels.

Retail spending remains subdued, although demand for services has been growing relatively
strongly. Over the past year, household consumption has increased broadly in
line with incomes, with the household saving ratio steady at around 10 per
cent. The ratio of household debt to income has declined modestly over the
past couple of years, with household debt increasing at an annual rate of 5
per cent, slightly below the growth in aggregate household income.

The housing market remains soft, with turnover rates around the lowest they have
been over the past two decades. Nationwide measures of prices recorded modest
declines over 2011, although there were signs of stabilisation in some markets
at the end of the year. Building construction activity remains subdued, in
part due to the earlier pull-forward of demand from the boost to first home
buyer grants, slower population growth, tight access to credit for developers
and lowered expectations of capital gains.

The unemployment rate has been steady at 5¼ per cent over recent months, after
increasing slightly around mid year. Measured employment growth has slowed
noticeably, following the strong growth in 2010. Employment has declined in
a number of industries, including manufacturing, retail and real estate, but
has increased strongly in others, particularly in mining. At the aggregate
level, additional demand for labour appears to have been met largely through
existing employees working longer hours, rather than an increase in hiring.
The forward-looking indicators point to moderate growth in employment over
the period ahead, although the Bank's liaison suggests that some firms
are looking for greater certainty about the economic environment before hiring
additional workers.

Growth in private sector wages is running at around its medium-term average pace,
while public sector wage growth has slowed over the past year. Outside of industries
exposed to the mining boom, there is little evidence of upward pressure on
wage inflation, with the moderation in labour market conditions over the past
year reducing the likelihood of an acceleration in wages.

The recent inflation data were broadly in line with expectations, with the various
measures showing underlying inflation of around ½ per cent in the December
quarter. On a year-ended basis, underlying inflation is running at around 2½
per cent, the midpoint of the medium-term target range, with the outcomes over
the second half of the year lower than in the first half.

On a seasonally adjusted basis, the headline CPI rose by 0.2 per cent in the quarter,
to be 3.1 per cent higher over the year. The outcome was again affected by
the price of bananas, which subtracted around 0.3 percentage points from inflation
in the quarter as supply recovered from disruptions caused by Cyclone Yasi.
The price of tradables (excluding food, fuel and tobacco) fell by ½
per cent in the quarter, with noticeable falls in the prices of cars and major
household appliances. Outside of these items, however, most other tradable
items recorded smaller price declines than in the recent past, partly reflecting
higher world prices.

In contrast, the prices of non-tradables continue to increase at a fairly firm pace,
rising by 0.9 per cent in the quarter and by 3¾ per cent over the year.
There were slightly above-average increases in the prices of a range of non-tradables,
including rents, communication, restaurant & takeaway meals and childcare.
While non-tradables inflation has slowed significantly since 2008, some further
moderation is likely to be required for overall inflation to be consistent
with the midpoint of the target range once the effect of the appreciation of
the exchange rate on tradables prices fades.

The Bank's central forecast for the aggregate economy remains for around trend
GDP growth over 2012 and 2013. Demand is expected to continue to increase more
quickly than output, with a significant share of the growth in investment met
through imports. Employment growth is expected to remain fairly subdued in
the near term, with a further small increase in the unemployment rate forecast
over 2012, before the unemployment rate declines again over the later part
of the forecast period.

The very strong growth in investment in the resources sector remains a key element
in the forecasts. This investment is expected to have positive spin-offs to
a number of other sectors, although the high exchange rate, fiscal consolidation
and subdued consumer spending on goods mean that overall growth outside the
resources sector is expected to remain below trend.

The major uncertainty regarding these forecasts stems from developments in Europe,
where there is still some possibility of an intensification of the sovereign
debt problems. While the likelihood of such an outcome seems to have lessened
a little recently, if it did occur, Europe would be likely to experience a
severe recession with spillover effects to the rest of the world through trade,
financial and confidence linkages. Australia is better placed than many other
countries to deal with this downside risk, given the scope to adjust macroeconomic
policy, the flexible exchange rate and the strong banking system. Nevertheless,
if this downside risk did eventuate, growth in Australia would be weaker than
in the Bank's central scenario.

In terms of domestic factors, it remains difficult to judge the net impact on
the economy of, on the one hand, a once-in-a-century investment boom in the
resources sector and, on the other, a high real exchange rate. With the exchange
rate having been at a high level for some time, a number of businesses are
reassessing their business models and medium-term prospects. Other businesses
are benefiting from the boom in the resources sector and from the lift in national
income from the high terms of trade. Given the historically unusual nature
of these events, there is, inevitably, considerable uncertainty about how these
factors will ultimately play out, with plausible upside and downside scenarios
for domestic growth.

The broad outlook for inflation is little changed from the forecasts published in
the November Statement. In underlying terms (excluding the introduction of the
price on carbon) inflation is forecast to remain around the midpoint of the
target range for most of the next couple of years, before increasing late in
the forecast horizon as the disinflationary effects from the exchange rate
appreciation diminish. In headline terms, inflation is expected to fall below
underlying inflation in the near term as the earlier spike in fruit prices
continues to unwind. Then, from the September quarter 2012, inflation will
be boosted by the introduction of the carbon price, which is expected to add
0.7 percentage point to headline inflation and around ¼ percentage point
to underlying inflation over the following year. This outlook for inflation
incorporates a modest slowing in domestic cost pressures. It also assumes that
the introduction of the price on carbon does not lead to second-round effects
on prices through higher margins or wage claims.

With the inflation outlook having improved late last year, the Board lowered the
cash rate by a cumulative 50 basis points at its November and December meetings,
after having maintained a mildly restrictive stance of monetary policy through
most of 2011. These reductions in official interest rates were largely passed
through to borrowers, so that most lending rates in the economy are now close
to their medium-term averages. At its February meeting, the Board judged that
it was appropriate, for the moment, to hold the cash rate steady at 4.25 per
cent, given that the central forecast was for close to trend growth in GDP
and inflation being close to target. The current inflation outlook would, however,
provide scope for easier monetary policy should demand conditions weaken materially.
Over the months ahead, the Board will continue to monitor information on economic
and financial conditions and adjust the cash rate as necessary to foster sustainable
growth and low inflation.